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Should Monetary Policy and Regulatory Policy Be Separate?

At the March Federal Open Market Committee meeting, the Federal Reserve opted to raise interest rates by 25 basis points on grounds that inflation was too high. At the same time, Federal Reserve Chair Jerome Powell maintained that the financial system was fundamentally sound. 

In doing so, the Fed followed its standard procedure of separating the conduct of monetary policy, which is geared to achieve low inflation and full employment, from regulatory policy that is intended to preserve financial stability. The basis for this distinction is that monetary policy should not be altered when a financial institution becomes insolvent unless it is systemically important—meaning that its failure could impact the banking system as a whole.

The catch is that while the definition of “systemically important” makes sense in theory, there are many gray areas in implementing policy.

Regulatory Response to Previous Crises

The clearest examples of bank problems threatening the financial system in the post-war era are the Less Developed Country (LDC) Debt Crisis of the early 1980s and the 2008 Global Financial Crisis (GFC). In the former case, money center banks were vulnerable because Latin American borrowers could not repay their loans. The regulatory response was forbearance, in which regulators refrained from marking the value of loans to market in order to buy time for banks to rebuild their balance sheets.

The cause of the GFC, by comparison, was the U.S. housing bust that resulted in massive losses on mortgage-backed securities. Congress enacted a $700 billion Treasury fund to purchase illiquid securities, but the proceeds eventually were used to recapitalize the largest institutions. 

The Dodd-Frank legislation in 2010 was intended to end the problem of “Too Big to Fail.” It defined systemically important financial institutions (SIFIs) to be those with $50 billion or more of assets and made them subject to stricter requirements on capital and liquidity. However, the definition was changed in 2018-19, when Congress exempted mid-size institutions with assets of less than $250 billion.

This change made SVB and Signature Bank exempt from the tests that applied to the largest institutions. Subsequently, when the U.S. policymakers granted full protection for their depositors on March 12, the rationale was they were systemically important institutions. Yet, when Treasury Yellen testified before Congress two weeks later, she denied that there was blanket protection for all bank deposits above $250,000. As a result, there is confusion about what systemically important means and how protected depositors will be from bank failures.

Regulators Don't Have a Grasp on the Number of Banks at Risk

The problem now is that regulators do not know how many banks are at risk from losses on their portfolios and potential deposit flight. A study by researchers at NYU estimates that unrealized losses on bank portfolios are in the vicinity of $1.7 trillion, which is substantial considering that Tier 1 capital of U.S. banks is $2.2 trillion. However, this only matters if banks do not hold bonds to maturity. Accordingly, Professors Steve Cecchetti and Kim Schoenholtz argue that bank supervisors need to do an immediate review of the balance sheets of the 45 banks with assets in excess of $50 billion to determine their vulnerability to deposit flight. 

In some respects, the closest parallel to what is happening today is the Savings and Loan (S&L) Crisis of the mid-1980s to mid-1990s, when one third of the S&Ls eventually failed. Despite this, the Federal Reserve did not have to alter monetary policy because many of the institutions were small and the closures played out over a decade. The main difference today is the deposit flight from troubled regional banks occurred in a few days, which has increased the risk of contagion. 


Bank Credit is Likely to Slow

While there is no way of knowing how widespread problems will become, what is clear is that bank credit is likely to slow. The Federal Reserve’s survey of senior loan officers shows there has been a tightening of credit standards at largest banks over the past year. Now, many of the small-midsize banks, which collectively account for about 40% of all bank loans, are likely to follow suit. This will impact smaller businesses and start-ups that do not have access to larger banks and is bound to weaken the economy and increase the risk of recession.

In the end, the Fed’s separation of monetary policy and regulatory policy is artificial. First, virtually every instance of major bank problems in the past fifty years has occurred against a backdrop of large interest rate increases. They are the catalyst for uncovering problems that were brewing when rates were low and credit was easy.  

Second, the track record of regulators detecting problems in advance is uniformly poor.  What is particularly troubling today is the failure of the Fed to act when bank supervisors raised red flags about SVB’s poor risk management. Furthermore, former Fed official Thomas Hoenig contends that risk-based capital measures did not take into account duration risk—the sensitivity of bank balance sheets to interest rate changes.

Finally, the recent developments have caused many observers to reflect on the famous saying, “When the tide goes out, you find out who is swimming naked.” The question now being asked is “Where were the lifeguards?”


A version of this article was posted to TheHill.com on April 3, 2023.

This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Opinions expressed in this commentary reflect subjective judgments of the author based on the current market conditions at the time of writing and are subject to change without notice. Information and statistics contained herein have been obtained from sources believed to reliable but are not guaranteed to be accurate or complete. Past performance is not indicative of future results. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of Fort Washington Investment Advisors, Inc.

nick sargen

Nick Sargen

Senior Economic Advisor
Nick is an international economist, global money manager, author, and contributor on television business news programs. He earned a PhD and MA from Stanford University and BA from UC, Berkeley.

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